Investors Flee Stocks At Precisely The Wrong Time

The percentage of American households owning stock mutual funds dropped to 46.4% in 2011, and it has fallen every year since 2008, according to Investment Company Institute. In addition, outflows from domestic stock mutual funds in 2012 neared the record-breaking pace of 2008, the worst year ever for outflows.

Pessimism has been rampant. As 2013 begins, worries persist over the long-term federal deficit. Modern Portfolio Theory, the intellectual underpinning embraced by academia for evaluating investments for the long run, is now derided by many pundits. The Wells Fargo/Gallup Investor and Retirement Optimism Index turned negative at -8 in November 2012, down from double-digit positive scores earlier in 2012. A belief that America’s best days are behind her seems pervasive.

How worried should you be? Maybe not as worried as so many others seem to be. Looking back at the historical performance of the consumer sentiment index versus the Standard & Poor’s 500 stock index indicates that periods of extreme pessimism are actually good times for stocks.

The most recent data from University of Michigan’s consumer sentiment index shows that that you would have to go back more than 30 years — to 1980 — to find consumer sentiment as low as it has recently dipped.

The accompanying chart shows the consumer sentiment index dating back to 1960, and about the only time sentiment was as negative as it has been over the past couple of years was in 1980. The plunge in consumer sentiment in 1980 followed a recession, an oil shortage sparked by the American hostage crisis in Iran, an annual inflation rate of 14%, and the bursting of a bubble in the price of silver after the Hunt brothers failed to corner the market in the precious metal. That confluence of calamities in 1980 kicked off a raging bull market.

Today’s economic worries are similar in many ways to 1980’s woes. Global turmoil related to America’s struggle with terrorism and Muslim fundamentalists dominates the headlines, threatening oil production in the Arab world. Massive monetary stimulus by the Federal Reserve has sparked inflation fears and the price of gold spiked higher than ever in the last couple of years. America seems unable to muster the strength to fight its fiscal crisis.

But just as happened in 1980, stocks over the past couple of years have marched higher. And, as the accompanying chart assembled by Fritz Meyer Economic Research illustrates, it’s not unusual for stocks to rise steadily higher precisely when consumer pessimism is at its worst.

Investor perceptions and consumer sentiment are often at odds. Wall Street reality—earnings growth and rising stock prices—governs stock prices. As a result, even as consumer sentiment plunges, you could see a rally in stocks.

To be sure, economic and political problems plaguing the U.S. are serious and must be addressed. The federal debt, downgrading of the U.S. Government’s credit rating, and threat of terrorism remain very real problems. But the pessimism these problems engender doesn’t necessarily stop the stock market from rising if corporate earnings growth holds up, and that’s what occurred in recent months.

In the aftermath of the 2008 global financial crisis, consumer sentiment has recovered. As history shows, however, it can take years for a full recovery in consumer sentiment to take hold. In fact, stock prices must rise for an extended period before consumer sentiment fully recovers following economic trauma. Stock prices are always out in front of consumer perceptions.

So, when you hear news about the extreme pessimism over the economy and record outflow from stock mutual funds, remember these lessons from history. The stock market in 2012 showed an astounding total return of 16%, while investors fled stock mutual funds in droves. Investors historically leave the stock market and become pessimists at precisely the wrong time. While past performance is never a guarantee of future results, it appears that familiar pattern was repeated in 2012.